In what seems like the good old days, we thought about many kinds of risk. Now, to many, risk only means one thing. All the other kinds of risk seem to have disappeared. Here are some of the classic risks as we learned them long ago, and still understand today:
Market Risk. Changes in equity prices or interest rates or currency exchange rates that hurt the investment value.
Liquidity Risk. Being unable to sell an investment without a discount for lack of buyers.
Concentration Risk. Having all your eggs in one basket, when the basket gets upset.
Credit Risk. A bond issuer might not be able to pay you back because of adverse conditions.
Inflation Risk. A loss of purchasing power over time because investments fail to keep up with a rising cost of living.
This old-fashioned approach to risk focused on possibilities for what might happen in the future. This makes sense to us, since the future is where we will get all of our coming investment results, good and bad. The past is past.
But perhaps the most popular approach to risk today is based totally on the past, not the future. Past volatility is supposedly the measure of risk in any investment and every portfolio. Modern Portfolio Theory (MPT) implicitly assumes that past volatility is the sole measure of risk. Yet volatility is inherent in any form of long-term investing, and has little to do with many of the classic forms of risk.
Investment firms and advisors promoting ‘risk analytics’ and many measures of ‘risk tolerance’ are using this backward-looking theory of risk. It has nothing to do with the classic definitions of risk, outlined above. In our opinion, some of the latest and greatest risk management technology is not focused on actual risk at all, and could discourage people from enduring the volatility required to achieve long term results.
Meanwhile, the classic understanding of risk has us thinking about its many dimensions as we choose securities and build portfolios. One drawback of our approach? It takes more work to do things the old-fashioned way. But we think it is the right way to go. No guarantees, of course.
Clients, if you would like to talk about this or anything else, please email us or call.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
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